Wednesday, November 12, 2008

Surprisingly Quick Confirmation of Ricardian Equivalence

A month ago the Treasury floated the idea of its purchasing equity stakes in banks, and I first explained how Treasury investment would crowd out private investment. Academics had ignored this point, and largely still ignore it.

Suppose the Treasury bought bank shares in the open market. That is, they traded cash-for-shares with existing shareholders. Why would those shareholders take their newfound cash straight to bank they had previously owned and ask for a new share issue? Professor Barro says that the shareholders would save their cash for future taxes they'll owe, but at the very least might we expect that they'd spend the cash on a variety of other things? In that case, the bank in question would have little or no increase in shareholder equity.

The actual Treasury transactions were not with shareholders, but with the banks themselves -- a trade of cash for new share issues. But why should it matter whether the Treasury deals with the banks or with the bank's shareholders? If it doesn't matter, then we are back to the conclusion that Treasury transactions do not boost shareholder equity.

I was fascinated to observe how quickly the world would learn that it really doesn't matter:

  1. First, the Washington Post and two Harvard Professors noticed that banks were not cutting dividends despite their massive losses. Dividend payments are one way to neutralize the Treasury purchases.

  2. Second, reporters noticed that PNC financial took its Treasury cash and immediately bought National City Bank.

  3. Third, reporters heard that JP Morgan Chase CEO told his employees that Treasury cash would help them acquire competitors.

All of this in only a few weeks! And I had worried that it would take years of careful academic study to prove my point.

Read all about this in my new Economists' Voice article "Is the Treasury Impotent?" Despite (or because of?!) the evidence that Treasury investments are not helping capitalize banks, Professor Mankiw still thinks they are a good idea.

1 comment:

jmsync said...

So you uncover evidence of what a Keynesian would label a liquidity trap (banks unwilling to leverage up) and promptly conclude you have proof positive of Ricardian Equivalence!

hmmm. Now I'm really confused by new classical macro.